The New York Times discusses a study (supposedly released, but the paper has yet to be posted) by corporate governance expert and Harvard Law School professor Lucien Bebchuk (along with Alma Cohen and Holger Spamann) on how much the top echelon at failed firms Bear Stearns and Lehman really suffered when their firms imploded.

The study rebuff the widely-held notion that the top executives suffered in a way that made a difference on a practical level. If you net worth goes from, say $200 million to a mere $100 million, the loss of 1/2 of one’s wealth at that level is not going to have a proportionate impact on one’s lifestyle:

“There’s no question they would have done massively better had their firms not collapsed,” said Lucian Bebchuk, one of the study’s authors. “But the wealth of those top executives was hardly wiped out. The idea that they were devastated financially has kind of colored the picture people have about what payoffs they were facing.”

Moreover, the research notes that the leaders of the firm had sold a fair proportion of the total shares they received prior to the crisis and discusses (as we have) that the proposed pay reforms are not much different from the measures in place at these firms pre-blowup:

Though the chiefs at both investment banks lost more than $900 million in their stock holdings, the professors argue that it is important to also consider all the riches the bankers took off the table in the years preceding the crisis.

At Lehman, the top five executives received cash bonuses and proceeds from stock sales totaling $1 billion between 2000 and 2008, and at Bear, the top five received more than $1.4 billion…

Many of the solutions that policy makers and regulators are considering for Wall Street pay are tactics that were already in place at Lehman and Bear. Both firms required executives to wait several years before selling their stock. Both firms paid heavily in stock…

However, the Harvard study says the executives may have had reason to focus on the short-term prices they could attain with stock selling.

The Times nevertheless manages to find some ridiculous counterarguments:
Some compensation experts said over the weekend that the study did not seem to prove that compensation caused the crisis and that it instead just pointed out that the bankers were wealthy.

“I don’t think anybody would question that they were well compensated,” said René Stulz, a professor at Ohio State University who has studied bank compensation. “It’s certainly true that the incentive effects are different if you’re already very wealthy, but that does not mean that the incentive effects are not there.”

It is simply amazing that people can throw out opinions like that and demonstrate their utter ignorance of how the industry once worked. Prior to 1970, all NYSE members had to be partnerships (and in those days, stock brokerage provided the bulk of industry earnings). That meant partners had their wealth tied up in the firm. The line at Goldman was that partners lived poor and died rich. When someone (back in the early 1980s, when comp levels were much lower than today) a top performing non-partner might make $600,000 to $700,000 a year. When he made partner, his take-home pay dropped precipitously to perhaps $100,000-$150,000 a year. New partners were under pressure to increase their ownership stake (by becoming even more productive) so they could get increase the cash potion of their comp. Moreover, if a firm went bankrupt, as Lehman did, the partners were personally liable. The creditors could seize their personal wealth. It would be impossible to see the pattern that Stulz noted, of top management being wealthy post bankruptcy.

And those pay based incentives DID matter. Goldman was incredibly risk averse, both from a legal standpoint and in how it was cautious about deploying its capital (that does not mean it was not greedy, please, but was greedy in ways that had low odds of hurting its franchise). The firm as a public company bears little resemblance to what it was as a partnership.

Don’t you think if you could lose pretty much all you ever made in very short order (recall Bear imploded over a mere two week period), that it would make you VERY mindful of what not just your subordinates, but also your partners were up to? It certainly did when the firms were privately held, and there is no reason to think it wouldn’t today. But now that Wall Street is hooked on other people’s money, there is no turning that clock back.

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22 comments

Very interesting post. This strikes me as the only reasonable comment I’ve seen on the compensation / risk incentives issue.

So we have a dual problem, then, even expanding the issue beyond financial firms:
– On one hand, top brass’ interests are more and more skewed to the shareholder interest at the expense of the workers and employees: they become wealthy by putting pressure on salaries and jobs, by reducing the share of the wealth that gets distributed in salaries,
– On the other hand, the dilution and liquidity of stock ownership reduces drastically the accountability of top brass to shareholders, which, in bulk, end up being the former workers who retired on their 401K and who, after holding the wrong end of the stick while they were earning a salary, end up holding also the wrong end of the stick when they become shareholders for their retirement.

In the early 1990s Goldman deployed a huge amount of capital going long Treasuries and Bunds, and was sideswiped when rates went up. Apparently they hadn’t realized that the long position in NY had been duplicated by an equally long position in London. I fondly remember watching the poor bastards sell every day, always a bit lower than the day before. It almost bankrupted the company; they had to sell a part of the firm to the Japanese, and forced Corzine out. This while GS was a partnership.

You have the timing and details on the Japanese wrong, which makes me wonder about the rest of your comment. Sumitomo Bank invested in Goldman in 1986 (November) and the Japanese approached Goldman. They hired Felix Rohatyn to make the pitch. That was their only Japanese investor. Sumitomo most assuredly did not put more in in 1992 (when Goldman hit the wall in the early 1990s); all Japanese banks were in huge financial trouble then.

That was a very bad downturn for Wall Street generally. 3/4 of the people in M&A across the industry were fired.

The other pressure on Goldman in 1992 was that a lot of partners went limited, which froze their capital accounts, leaving the rest to bear the losses.

Yep, sorry, you’re right, I meant the Bishop Estate (Hawaii), not the earlier injection from the Japanese. And I also got the Corzine part wrong. The Treasury fiasco was what brought Corzine in (and it was Friedman who got the boot).

But to stress the fact (see the link) – in the 1990s, when Goldman was a partnership, it was not risk averse. So I think Yves is confusing the structure of the firm with the spirit of the age – *all* of Wall Street was more risk averse in the 1980s, and *all* of Wall Street was less risk averse in the 1990s.

Not as much as you suggest. Someone I know who is in a position to know says the firm did change pretty dramatically after it went public. And if you look at its mix of businesses, it was pretty balanced as of 1999 and has shifted very sharply since then to trading.

To put Professor Rene Stulz’s comment in context, it may be helpful to know that for many years now he has regularly offered to serve, and has in fact served as a consulting and testifying expert, in financial economics, for companies involved in corporate and securities lawsuits.

One of the things that I’ve decided in the last year is that the limited liability corporation is the original source of moral hazard in our modern economy.

What Yves says about personal liability affecting one’s decisionmaking is entirely true. If ALL of your wealth is put at risk in everything you do, you behave much differently than if none or only a portion of your personal wealth is put at risk. Adam Smith’s “invisible hand” aphorism and argument for what has become known as laissez-faire were formulated in an era that did not have the modern corporation in which the primary economic actors were people who were subject to existing laws that made them personally liable for everything their business did. Smith was able to argue that no further laws regulating the market were required because the managers and owners of the business already had to comply with laws that ensured their good behavior consistent with the common good.

But the modern corporation is not the only source of moral hazard, nor is it the worst. For example, being a publicly held corporation amplifies the skewing of business decisionmaking even further because perception of performance often means more than actual performance. This leads to putting the management at odds with the shareholders, resulting in less information flow to shareholders about the real status of the company.

As much as I hate to say it, though, what puts the icing on the cake and creates the trifecta of moral hazard for publicly held corporations are the government guarantees, which can lead to looting of the corporation by management.

For an excellent analysis of looting by management, see George Akerlof’s and Paul Romer’s 1993 article, which describes a lot of what we’ve seen. You can purchase the article here:

1. Corporations did exist in Adam Smith’s time, in the form of joint stock companies. In fact, Smith dedicated a few pages in Wealth of Nations criticizing them for the very idea you note – that the separation of ownership and management creates perverse incentives.

2. Smith only makes mention of the “invisible hand” once in Wealth of Nations and once in Theory of Moral Sentiments. That’s 2 references in over 1,000 pages of writing. It was not a central theme.

3. Smith never argued for an unregulated market. On the contrary, he argued for numerous regulations, the most well known being usury laws capping the rate of interest on loans.

1. Sorry, the modern corporation did not exist in Adam Smith’s time. Yes, joint stock companies existed then, but joint stock companies in Smith’s time were not perpetual entities with all the rights of citizenship that we have today. Joint stock companies in Smith’s day lived and died at the sufferance of the sovereign. The rise of the modern corporation in America can be traced to a Supreme Court decision in 1886, around 100 years after Smith died.

2. I know how unimportant the Invisible Hand is in Smith’s planned trilogy (of which he only finished the first two volumes; the third was to be about jurisprudence). The problem is that the dominant strain of neoclassical economics that has gotten us into this mess has done so by invoking the Invisible Hand as justifying unfettered, unregulated markets. You may have to go back to what was written in the 1940’s and 50’s to find such blatant advocacy, but it’s there, if you look.

Frankly, this push back on my point reminds me of all the people who touted the wonders of the free market from 1995 until about 2007 who started arguing that we don’t have a free market when things went south. I’m not the one who relied on a perversion of the Invisible Hand aphorism to foist dangerous ideas like “there is no society” upon us, and I’m not going to ignore the opportunity to attack what they’ve done. Whether or not the Invisible Hand aphorism is central to Adam Smith’s books, many economists including Milton Friedman adapted it to justify neoclassical economics.

3. I was unaware of Smith’s arguments in favor of usury laws (the language can make my eyes glaze over), but I’m not surprised. Usury is just a form of extortion (he even says “the extortion of usury”).

But what Smith actually advocated is primarily helpful in debunking the adherents of neoclassical economics who ARE market anarchist nutjobs. Make sure to watch Frontline on PBS tomorrow. The link below includes two short previews, one of which includes an advocate for credit card companies arguing that capping interest rates for credit cards (i.e., anti-usury measures) violates free market principles.

Once your tangible net worth goes north of $100 million, your needs, if you are sensible, change quite dramatically. I can, and have, set a portfolio that will provide upwards of $3 million a year free of Federal taxes. Now if you lose 50%, your tax free income will be $1.5 million/year. Again, if you’re sensible, you don’t really know that it happened.

For those on Wall Street, while tangible net worth is important, it is the game that matters. These are pit bulls all of whom want to be the alpha dog.

As to compensation. If memory serves it was a NYSE rule that required that all members be partnerships. The intent of the rule was joint and several liability. The focus here is the enforcement of responsible conduct thru the incentive of liability. Thus, at a given point in time a trading firm, like GS, might appear to have a high risk book. That circumstance never lasted very long under the partnership regime because the book was marked to market at the close of every trading session.

The move toward the corporate structure began in the late 1960s when underwriting firms developed a two tier structure; the partnership for their NYSE activity and a corporation for underwriting and investment banking. It is instructive to understand that the transition to the corporate structure was not so much about other people’s money as it was about liability. The corporate veil was/is good protection for one’s personal net worth.

The eggregious bonuses that are being paid are the result of the abrogation of personal liability. The Street has executed a trader’s work-around and made moot the concept of liability. Reintroduce personal liability coupled with deferred vesting of bonuses and you will begin to fix an important part of the current mess.

Ives, it seems to me you, Tao and Siggy, have really described a criminal racket “legalized” through a hostile takeover of government by bribery. Is this a repeat of earlier crises like the gilded age and the roaring twenties, or has the corporate charter changed significantly to alter the “natural” outcome (a purging crash)?

Almost by executive fiat, FDR in his time, was able to reset the crooked game. But today, despite the hopeful synchronicity in Obama’s inauguration today, he seems unwilling or unable to effect any reform as promised. Can this version of rigged-market cannibalism end peacefully, and can free-enterprise be revived in a sustatinable way?

I think it will take another Great Depression for anything to really change. Unfortunately, continuing on our current path is making that very likely.

In the last 20 years or so, the balance of power has shifted towards the elite to an extant which will make it very difficult for ordinary citizens to make much change. The deck is stacked against them; whether it’s tax law, campaign finance law, disclosure laws, or any of the other means of concentrating and maintaining wealth that the elite currently have.

To compound the issue, systemic complexity and the voter’s grasp of the issue have been moving in opposite directions for quite some time. Your average voter today has neither the time nor the inclination to do much more than memorize sound bites. This is bad because the average voter is the only one who can change the system; the elite, who can afford to research the issues, and basically write all of the laws, seem content to take as much as they can while they can.

So I believe it will take a major economic event to make any real change. 25% unemployment will give people a little more time to research the issues, and widespread poverty might give them the motivation to act.

Hopefully this will be done in a peaceful way; but the longer it takes, and the harder the fall, the less likely a peaceful resolution will be.

“Effectively financiers had professional liability exposure just like doctors — and the market was the arbiter of misconduct.”

But doctors buy insurance … though I believe that Yves Smith has in the past suggested a similar remedy?

The motif here returns periodically. I am not unsympathetic – skin in the game and all that. What prompted the partners to go public and make themselves into Corporations? By confession, I don’t know – but I have to suspect their doing so was their “rational” response to options presented them. What’s rational for me does not trump what’s rational for you, so what’s the ground for holding people accountable as they used to be? Is this a moral argument?